Much like the New York Stock Exchange, Bitcoin exchanges have suffered from their first massive loss -- a virtual "Black Friday", so to speak. (Source: Google Images)

Some say Bitcoins could make buying illegal drugs easier. However, in reality Bitcoins are far from "untraceable". (Source: YouTube/Beardo/Dirt Nasty)

Mt. Gox is the world's largest bitcoin exchange, but it's suffered from major liquidity issues in recent weeks. The recent massive inflationary drop is also a sign of poor controls at the exchange.

Currency experiences massive inflation in a single day, markets stay open

The day was October 28, 1929 and the sky was falling. That Monday the DOW Jones Industrial Average (DJIA) fell 12.82 percent. History books show that the next day the DJIA bled another 11.73 percent. Vast amounts of wealth were wiped out in an instant.

Today modern exchanges automatically close to prevent such catastrophic sell offs. Or, they do in the real world, at least. But on June 10, a new kind of market -- Bitcoins suffered a massive decline, that may signal the start of the world's first digital depression.

I. A 30 Percent Decline in One Day

This Friday the New York Stock Exchange (NYSE) was hammered, losing 172.45 points (approximately a 1.4 percent dip) to close below 12,000 for the first time since March 18, 2011 -- nearly three months ago. Traders greeted signs of slowdowns in global markets with serious concern.

But as bad a day as Friday was for NYSE traders, it was far worse for those who invested in an increasingly popular digital currency -- Bitcoins (BTC). At the opening bell at Mt. Gox, the world's largest Bitcoin exchange, a single BTC cost $28.919 USD. By mid-day that total had plunged to $20.01 USD -- a drop of 30.8 percent.

Granted, in recent weeks the market for Bitcoins has soared upwards, nearly tripling, due to increased demand and built in technical issues. So perhaps this inflation was merely reactionary. Nonetheless, it took many by surprise, as inflation on this scale had never before been seen in the fledgling Bitcoin market.

But, wait let's not get ahead of ourselves. Why should anyone care if the Bitcoin market crashed?

Well, today on Mt. Gox alone, approximately $2M USD in Bitcoins were bought and sold in 5,871 trades. That's unusual in and of itself -- only a total of $19M USD in trading volume occurred over the past six months.

The bottom line is that several things are clear from today's trading.

1. The Bitcoin market endured its first digital equivalent of a "bank rush" with people rushing to exchange their BTC for U.S. Dollars. 2. People have a large amount of money -- millions of USD sunk into Bitcoins lost big in the flash crash.3. Unlike modern markets, which automatically close to prevent massive inflation, the digital Bitcoin markets stayed open.4. Something major is moving the Bitcoin market in a sharp inflationary direction, in contrast to the predict deflationary trend

So what are Bitcoins and why is this intriguing? Let's take a look.

II. What is a Bitcoin?

Bitcoins [wiki] are virtual currency similar to the Linden Dollars (L$) used by Second Life users.

However, unlike L$, which are ultimately controlled by Linden Labs, a company (or "governing body" in some people's eyes), BTC have no central authority. The currency instead relies on a peer-to-peer system where everyone logs transactions and monetary events, prevent false transactions.

Also, unlike the L$, the focus of BTC is to exchange the virtual currency for real world services, not virtual ones.

People can obtain Bitcoins in two ways -- buying them or generating them.

To generate them, you have to run a complex math hashing algorithm, which tries to find a new bitcoin "block". Parallel computing devices -- namely GPUs have shown themselves most capable for this task. In fact with modern AMD GPUs it is possible to "break even" on your hardware costs by generating Bitcoins.

The other method of gaining Bitcoins is to purchase them at an exchange -- the largest of which is Mt. Gox. For a full list of exchanges, refer here.

III. Are Bitcoins Anonymous?

One of the biggest monkeys on the back of Bitcoins is public misconceptions about privacy.

For example a Reuters report quotes a letter from Senators Charles Schumer (D,New York) and Joe Manchin (D, West Virginia) wrote to Attorney General Eric Holder and Drug Enforcement Administration head Michele Leonhart stating:

The only method of payment for these illegal purchases is an untraceable peer-to-peer currency known as Bitcoins. After purchasing Bitcoins through an exchange, a user can create an account on Silk Road and start purchasing illegal drugs from individuals around the world and have them delivered to their homes within days.

Now this is somewhat misleading in that Bitcoins themselves can be more or less traceable than how the user communicates with uses their IPs. Any time a transaction occurs, it's sent out from an initial IP to nodes on the Bitcoin network, which verify its authenticity.

Take Silk Road, for example -- the topic of a recent Gawker piece. An IP accesses this site, which is known for selling narcotics illegal in the U.S. If this is a user's direct IP, anyone who can sniff the traffic of the site can trace that user back to their home address, assuming cooperation of the internet service provider.

However, if you first route your IP through Tor -- an anonymizing service, you can make it extremely difficult for anyone to trace you. This is because BitCoin "accounts" are regularly generated and a single individual holds keys to multiple microaccounts rather than a single large account. To an outsider, this account is just a random-looking string -- nobody can tell who owns it. But using your personal key, you can sign transactions on the accounts you own.

As long as the public/private key cryptography scheme is sound, and you anonymize your IP, even the government will have a relatively tough time tracking you. The same can be said about any activity that occurs online.

That said, there's numerous ways your privacy could be compromised if you're buying drugs or performing elicit activities. Some points of possible attack include:1. Failure to anonymize IP due to using your direct ISP-provided IP address.2. Failure to anonymize IP due to misconfiguration of Tor or other anonymizer (a surprisingly common occurrence).3. Tracking of physical goods associated with purchases.

Wait, you say, how could #3 occur? Well, let's say you order a kilo of powder cocaine, using your Bitcoin treasure trove. Well the kilo comes from a well known dealer who's being monitored by law enforcement for their real world activities. Law enforcement note the package arrives at your house. They wait for you to take it in and then begin using it. They obtain a warrant and raid your house.

Remember, almost no "drug dealer" is going to be exclusively doing business via Bitcoins. So they're likely engaging in real world transactions that will make it likely for law enforcement to inspect anything they decide to mail.

In other words Bitcoin does provide users with a bit of anonymity, but to claim it's generally "untraceable" in principle is pure paranoia on certain government officials' and journalists' part. Bitcoin-driven transactions are very traceable; it's just that so far nobody has been interested in investing the large amount of effort it would take to trace them, as they have with copyright infringement or child pornography.

The DEA's response indeed seems to hint at this. Reuters quotes agency spokeswoman Dawn Dearden as stating, "The DEA is constantly evaluating and analyzing new technologies and schemes perpetrated by drug trafficking networks. While we won't confirm or deny the existence of specific investigations, DEA is well aware of these emerging threats and we will act accordingly."

IV. A Big Problem -- Getting Money In Or Out

While the threat of the U.S. government taking some sort of action over anonymity fears is certainly looming over the Bitcoin market, a far more serious problem is liquidity. In the traditional global currency markets, you can instantly exchange your currency for other foreign currencies on a number of exchanges. These exchanges can take bank wires or funds from digital accounts, such as Paypal.

By contrast Bitcoin exchanges like Mt. Gox do not accept debit/credit transactions. Up until last week they did accept eBay, Inc. (EBAY) subsidiary PayPal. However, PayPal has blocked transactions to the site. This is because PayPal has a policy against virtual currencies.

With an easy PayPal route gone, market liquidity was dramatically reduced. This may be a major cause for the market crash.

Currently the most well published ways to convert Bitcoins to USD or vice versa is to use Dwolla or Liberty Reserve. These methods are relatively straightforward, but transactions through these online billing services often move at a glacial pace, hampering liquidity. API problems with Dwolla further exacerbated the liquidity issues in recent weeks at Mt. Gox.

You can also mail a check to a certain individual known as "Bitcoin Morpheus" listed at the exchange, who will add funds to your Mt. Gox account. Granted this route might not be for the faint of heart as it seems rather "unorthodox" to say the least.

Now there is another method that could work slightly faster than any of the above. For now you can use a variety of means to quickly buy L$ (Second Life currency) and then use the virwoxSLL exchange to exchange L$ to BTC. The purpose of L$ and BTC is quite different, so it's unclear how long this route will stay viable, and many people don't realize you can get Bitcoins in this fashion.

At the end of the day Bitcoin has a very real liquidity problem.

V. What's Next for Bitcoin?

Unless Gawker and other media outlets can drum up enough unfounded paranoia about peer-to-peer currency to evoke some kind of draconian action by the U.S. federal government, it's unlikely that Bitcoins will go away.

However, market volatility poses a very serious risk to BTC users -- be they miners, traders, or merchants who accept BTC as payment for goods or services. To that end, a major improvement would be for Bitcoin exchanges to implement mandatory market closures if the currency value dropped below a threshold. In theory this would be relatively easy to implement, and we expect that it will be done at some point to prevent one-day flash inflation/deflation.

At the same time, a viable billing service must step up and offer people the ability to use credit or debit card billable transactions in USD to buy bitcoins quickly and directly on a major exchange (e.g. Mt. Gox). If this can be done, market liquidity can be restored and the currency will once more flourish.

Last, but not least, concerns about deflation must be addressed as demand grows and production slows. As mentioned in the introduction, if deflation is not controlled, reactionary inflation spurts could be experienced. Indeed, a reactionary market movement could have been part of the cause for today's record-setting inflation.

It is possible that additional bitcoins could be distributed or other mechanism employed to prevent deflation, much as they are with standard currencies.

Bitcoins are certainly a novel idea in their implementation details and purpose. This article offers an introduction, but barely skims the surface of this phenomena and the true facts about it.

Ask some and they'll say Bitcoins are a scam/pyramid scheme. Ask others and they'll say the Bitcoin market has the promise to offer sustained success. There's valid arguments on both sides, but at the end of the day Bitcoins will still be around for the forseeable future.

In trading late Friday, Bitcoins recouped nearly half their losses, bouncing back to 24.34. That's still a massive crash -- around 15 percent in one day. But it shows that the market isn't dead. The U.S. economy survived Black Friday and today sustains a massive amount of wealth. Likewise, perhaps the Bitcoin movement can survive this tough time and find its way. After all -- people are still buying Bitcoins.

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" Bitcoins will never be anything but an oddity since there is an artificial limit to how many can be created."

There will be 21 trillion microbitcoins created, which will each be divisible to two decimal places. That's enough units of exchange for internet commerce.

"The system is designed in such a way that early created coins become more and more worth over time."

Early coins are worth no more than later coins.

"This is considered gray area when it comes to legality. The legal system just works too slow, so the scheme is probably completed before the court rules."

How is someone creating a product and other people freely deciding to buy it or use it illegal? People like you just love government tyranny and control over other people. You would have liked the Stasi in East Germany.

"I wouldn't be surpriced if the authors only purpose is to create more attention to a get rich scheme he is part of."

In a Ponzi Scheme, the founders persuade investors that they’ll profit. Bitcoin does not make such a guarantee. There is no central entity, just individuals building an economy.

A ponzi scheme is a zero sum game. Early adopters can only profit at the expense of late adopters. Bitcoin has possible win-win outcomes. Early adopters profit from the rise in value. Late adopters profit from the usefulness of a stable and widely accepted p2p currency.